Backdoor Roth accounts can be a good deal for wealthy

This fancy mega backdoor Roth retirement savings advice isn’t for everyone — including me. I freely admit it.

But for the fortunate few to whom this applies — you’re welcome. For the rest of us, well, just know that retirement tax law creates amazing opportunities for people with great incomes and great 401(k) plans who can invest for the long-term.

As a reminder of the two main tax-advantage categories of retirement accounts: Traditional IRAs give you a tax break now and you pay taxes later. With Roth accounts you pay taxes now, but you get a tax break later.

To make this fancy mega backdoor Roth move, you’ll need the following special conditions:

1. You’ve already maxed out your $19,000 per year pre-tax contribution to your workplace 401(k).

2. You have a workplace 401(k) that allows for “after-tax” contributions above the $19,000 limit. Some do, some don’t.

3. Your workplace 401(k) allows you to roll over balances to an individual IRA while you’re still working for your employer. In other words, you don’t have to “separate from service” in order to roll over 401(k) balances. Again, some companies do, some don’t.

4. You have extra money to fund a Roth IRA retirement account.

If you meet all of those conditions, this one’s for you.

Here’s what you do:

First, fund your $19,000 per year limit in your 401(k). Good job. Awesome.

Next, contribute additional funds — from income that you’ve already paid taxes on — into your workplace 401(k). This seems weird, but it’s a necessary intermediate step toward creating your Roth IRA.

How much after-tax income can you send? It depends. If you get an employer match this year, then that limits your after-tax contribution. By how much?

$56,000 is currently the maximum amount that anyone can stuff into a 401(k)-type retirement account per year, including employer matches. So, if you put in $19,000 already, and your employer put in $7,000, for example, then you could put another $30,000 into your account, because $56,000 minus $19,000 minus $7,000 equals $30,000. Got it? Good.

OK, now step 2. Pretty much right away, request a rollover of your $30,000 after-tax contribution (or however much you put in) into a Roth IRA at a brokerage account you’ve opened. This brokerage account is totally independent of your workplace 401(k). This $30,000 of after-tax money then becomes your Roth IRA account.

(A couple of comments about step 2: This all depends on having a 401(k) plan that allows you to do rollovers before you quit or retire from your job. Again, some 401(k) plans do, and some don’t. So you’ll want to check on that before embarking on the mega backdoor Roth plan.)

Next — and here’s where the whole thing becomes a little persnickety and annoying — you need to treat any gains in your 401(k) portfolio in a specific way. During the time your after-tax contribution sits inside your workplace 401(k), you may get interest income, dividends or capital gains, even if it’s there for a very short time. When it comes time to roll your after-tax money into a Roth IRA, you can take all that after-tax contribution plus gains into the Roth. But you can’t take the gains from your regular pre-tax contributions because that’s not cool with the IRS.

Finally, once you have funded your Roth IRA through this backdoor, understand that you’ve already paid taxes on this retirement money, so you’ve got yourself a powerful tax-free income source in retirement. Congratulations.

A couple of other comments: While I believe in paying taxes, I also believe in taking advantage of existing tax law to shield wealth and income. So far, this is all legal and cool.

This is also some next-level trickiness in retirement savings that requires high income, attention to detail and the luck of specific 401(k) rules that many people do not have access to. But if you’ve got all that, the mega backdoor Roth is super compelling.

One of the coolest parts about this, if you are a high earner with extra cash available for investing, is that Roth IRAs are otherwise hard to fund. The normal rules for Roths say you can’t put money into a Roth if your income is too high. If you’re single, you start to lose rights to contribute to an IRA when you make $122,000 or more. If you’re married, you start to lose rights to contribute to a Roth IRA if you together make $193,000 or more.

This may sound like a “problem” for high-income folks. But the fact is that normal Roths are generally for people who don’t make very high salaries. The mega backdoor is this secret workaround that high earners have, and that many probably don’t know about. Now you know.

Finally, do I think Roths are inherently better than traditional retirement accounts? Not definitively.

Why? Because we don’t know what tax rates will be in the future, so it’s not knowable which type of retirement account is mathematically superior.

However, having a blend of Roth and traditional retirement accounts introduces flexibility in your retirement planning that allows you to adjust to whatever tax rates are in the future.